My new Advisor Perspectives column, "How to Use Bond Ladders in Retirement Portfolios" is now available. I was working on this column at the same time I wrote my recent post on how to build a bond ladder with TIPS.
In this column I investigate the use of Treasury Strips to build bond ladders of different lengths as part of a retirement income strategy. The retiree maintains a bond ladder of a given length as a front-end income floor to cover their lifestyle needs, and then invests the rest of their financial assets in the stock market. I was trying to figure out what might be an optimal length for the bond ladder. It turns out, as is often the case, that there are various tradeoffs involved [upside potential vs. downside risk] and there is no clearly optimal bond ladder length. Different folks will have different preferences and different answers. I provide some figures to help aid decision making for this. One conclusion which does emerge is that there is relatively little additional safety to be gained from extending the bond ladder beyond about 20 years.
I wonder how your analysis would have been impacted if the ladder length was allowed to fluctuate depending on the relative performance of stocks and bonds? In years when stocks outperformed, liquidating these for retirement income and using the maturing bond assets to replenish the ladder; in years when bonds outperform, using the maturing income to meet retirement spending needs and waiting to replenish the outer rungs until stocks outperform again.
ReplyDeleteOr what if the ladder was never replenished but used as a hedge against a poor sequence of returns during the first 10-15 years of retirement, followed by a more traditional total return approach after that?
I also wonder what the effect would be if less of an attempt were made to offset inflation? While this would result in a greater need to tap into stocks in later years to meet spending needs, there would still be a net benefit in terms of insulating a core amount of retirement income need from sequence of returns risk in the initial years of retirement.
Thanks Joe.
DeleteAbout varying the length of the ladder in response to the returns on the growth portfolio, I believe this is what is generally done in practice. It is something that can only be examined with historical data. I was using Monte Carlo simulations which assume that stock returns are independent from what happened in the past. With this assumption, it would just be random whether a varying ladder length would beat a fixed ladder length. In practice, having the rolling ladder length sounds like a good idea.
Shortening the ladder as retirement progresses also sounds feasible and would result in a rising equity glidepath. Your idea about having less inflation protection built into the bond ladder would also have the same general rising equity glidepath effect.
Thanks.
Wade-- You state in your article that "It is feasible to build a ladder of approximately 27 years. Beyond that, the costs exceed the assumed wealth of $100."
ReplyDeleteTechnically, this is true IF you calculate a 4% starting withdrawal rate for a strips ladder. But with a slightly lower withdrawal rate -- about 3.7% -- you can indeed purchase a 30-year strips ladder for $100 using your bond prices. Or, if you assume that average long-term inflation is closer to about 2.3%, you can still get that 4% withdrawal rate for 30 years with $100. Of course, your TIPS ladder got to the 4% withdrawal rate very nicely at any inflation rate. Whether to use a TIPS or a strips ladder (or some hybrid with both as a partial inflation hedge) is largely going to hinge on one's long-term inflation assumptions and degree of confidence in them and in the Fed's inflation-fighting capabilities.
Thanks. I agree with all of your points.
DeleteUnder deflationary or very low-inflation scenarios -- not exactly a popular planning topic -- the strips ladder would do considerably better than the TIPS one. TIPS have some downside protection (e.g., guaranteed minimum of par value at maturity) against extended deflation, but many of the TIPS that have been out for years could fall a very long ways to get to par.
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